Currency game risky for advisers
To hedge or not to hedge, that is the question advisers are asking themselves as the volatile New Zealand dollar continues to make headlines and affect returns.
Tuesday, May 1st 2012, 6:39AM 
4 Comments
by Niko Kloeten
Trading at about US82c overnight, the dollar has become a political issue in recent weeks, with calls from the Green Party among others for the Reserve Bank to intervene to bring it lower.
Meanwhile, opinions differ widely as to what direction the dollar is likely to head, particularly against the greenback, with forecasts for its value over the next year ranging from US65c to US90c.
It's perhaps not surprising, then, that many advisers choose not to currency hedge their clients' overseas investments; not only is it easy to get their picks wrong, their hedging can also contradict or even exacerbate the currency position of the funds their clients are invested in.
Norman Stacey of Diversified said his company used currency hedging, but only occasionally.
"Our default position is unhedged, unless we take a strong view one way or the other," Stacey said.
Changes in the relative value of the New Zealand dollar can have a big effect on returns, sometimes flattering and sometimes making performance look decidedly ugly, he said.
"Over a given period currency movements can overwhelm other movements in the portfolio."
Murray Weatherston of Financial Focus said, "A lot of people use the policy of least resistance; you hedge 50% so you're half right and half wrong.""
However, his view is not to try to hedge because in the context of longer term assets the currency will tend to "come out in the wash," he said.
Trying to pick currency movements can be risky for advisers, who don't "spend all day staring at screens" unlike currency traders, according to Weatherston.
"I don't know of anybody anywhere in the world who would claim to be accurate on currency forecasts over an extended period of time."
Niko Kloeten can be contacted at niko@goodreturns.co.nz
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I think the key thing for managers, advisers (and investors ) to realise is that ignoring currency impact is no longer a defensible option. Ignoring the impact of currency (i.e., being fully un-hedged) is as strong a view as hedging. A source of portfolio return (or risk) and volatility cannot be wished away just by ignoring it.
Choosing the right hedge ratio is as Murray points out difficult, and currency predictions are typically of low value. But over long investment horizons it is also quite clear (from historical data) that owning US equities with a 50-60% hedging ratio generally provides the lowest volatility outcome, owning US equities with a 100% hedging ratio generally provides the highest return outcome in NZD terms. (This may not of course be true over short time horizons.) Zero hedging has historically been the worst outcome for a NZD investor in US equities - in terms of both volatility and return.
Current high (historically at least) levels in the NZD make a hedging view even more difficult, but we do live in a QE world still. Sometimes the best currencies (like the NZD)are the “least worst”.
Hedging only becomes problematic because advisers insist on building DYI portfolios comprising of a range of funds like Platinum, Magellan, Hunter Hall, and various UK listed trusts (each of which have not actually been designed to provide Kiwi investors with a global equity exposure). For me the poor performance that has resulted in the last 5 years from the inability to hedge properly is more of a down fall of this type of DYI approach, rather than a problem with currency hedging.
Can't imagine this little rant will make me too popular with all those broker groups who insist that "listed UK trusts" are the only answer! Then again - looking at the performance of a couple of KiwiSaver funds at the moment, I would guess they have more pressing problems......(although I might be thinking that there is a common link in here somewhere).
Maybe Norman did find a way to short the dollar.....as it would be the only thing that would explain this (Headmaster, you just might be on to something here).
Given that listed NZ property returned 17.5% for the year, following by NZ bonds at 10.1%, global bonds at 9.5%, NZ shares at 3.6%, hedged global shares at 3.2%, cash at 2.8%, and unhedged shares at -6.4%, you would have to dream up a pretty interesting strategy in order to produce a balanced fund return of -10.3% for the year (in fact this just doesn't actually look plausible, so maybe I have had too many red wines for the night).
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One could not take a stronger view on currency than to be fully unhedged. One cannot go “one way or the other” from that position, save shorting the currency (synthetically or otherwise).
A difficulty is that the article does not refer to the type of security involved, whether bonds, equities or some other type of security. That does not simply matter, it matters decisively.
Global bond investors here, for example, routinely hedge 100% back into New Zealand dollars, as small currency movements can create or destroy value much greater than the average annual yield which bonds produce, a risk which the bond investor is typically seeking to avoid.
The position which Murray Weatherston indicated, of hedging to the extent of 50%, is the ‘default’ position for a number of large global equity investors. As the position of least regret, it is a defensible position to adopt when one does not hold a view one way or the other on currency movements (or would rather not hold a view).
The tax position of the investor is important. If returns on hedging contracts are taxable as income, a 50% hedge would need to be grossed up (1 – t/100) in order to achieve a net 50% position.